Look to emerging markets and bonds
Updated: 2010-02-10 07:37
(HK Edition)
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A debt crisis is looming in the developed Western economy; a crisis that is being treated with yet more injections of debt.
In addition, the long-term forecasts for advanced G20 nations government deficits show them rising to unsustainable levels due to the growing burden of providing healthcare and pensions to an aging population.
The biggest risk on the horizon is that it will require a crisis before policy is changed sufficiently to reverse this trend.
Governments face three choices: default on the debt, repay it or inflate the debt away. The first option is unthinkable for governments. The second looks unrealistic. In this context, the latter option is increasingly likely raising the question of the real value of these bonds. Outside of inflation linked debt, where then should sovereign bond investors turn?
Emerging market countries are well placed to deal with the twin concerns any bondholder has: the ability and the willingness to repay debt.
The contrast between the emerging market and the developed market cannot be clearer right now. The largest constituency of borrowers today are developed Western governments, while emerging market countries have an increasing share of world growth and have current account surpluses, meaning they are typically creditor nations and providers of capital to the indebted Western world. For example, China has become the largest holder of US bonds over the past year, and the amount is still growing.
It is increasingly recognized that a structural change has occurred in the global economy - it is the emerging and not the developed economies that are now driving global growth. Over the last 10 years emerging economies have strengthened and have moved to where they are growing 3-5 percent faster than the developed economies every year. In 2009 the emerging markets are set to account for over 100 percent of global growth and it seems they will continue to dominate.
Emerging markets are also supported by structural factors. The growth of the emerging markets is increasingly driven by domestic demand, meaning that they are less susceptible to slumps in demands in the developed world. In general, in the emerging world, we have high saving ratios, low levels of debt and prudent lending policies. Demographics are also favorable: a classic population structure of more young people and relatively fewer older people, and a rapidly growing middle class. This gives emerging markets the critical factor that lenders want - an expanding tax base.
This dynamic is already reflected in the credit metrics. The October IMF World Economic Outlook projects that UK debt/GDP will climb from 68.7 percent in 2009 to 98.3 percent by 2014. Indonesian debt/GDP is expected to fall from 31.5 percent to 27.1 percent and Brazilian debt/GDP from 68.5 percent to 58.8 percent over the same period. Valuations have yet to catch up with this dynamic. UK 10-year gilts yield around 4.0 percent versus around 9 percent and 10.5 percent for Indonesian and Brazilian 10 year bonds. In terms of risk versus reward, we are very clear about to whom we prefer to lend money and it is not to the indebted Western world.
Brazil, one of the key trading partners of China, illustrates the credit worthiness and structural themes very well. At the height of the financial crisis Brazil provided US$10 billion to the IMF. In this context it is not surprising that Brazil has been upgraded to an investment grade country by all of the major rating agencies. Preparations for the 2014 World Cup and 2016 Olympics also demonstrate the amount of investment that will be required over the next few years. This opens up another opportunity for bond investors: emerging market corporate bonds and in particular those issued by strategic infrastructure assets. Bonds issued by select Brazilian steel companies and airlines could perform well over the next few years, given the pace of infrastructure spending as Brazil gears up to host the Olympics.
2009 was an easy year for bond investors, apart from developed Western government debt, everything rallied. 2010 will be a lot more difficult. As banks continue to contract balance sheets and borrowers continue to turn to bond markets for financing, bond managers in their role as loan officers need to discriminate between borrowers. This starts at the sovereign level.
Asian governments and investors are sitting on big pile of cash now, and the recent rumors about China buying Greek bonds highlight just how the money in this region is wanted elsewhere. Bond investors are essentially money lenders and it is obvious that money should be lent to those who can pay back. As Jesse Holman Jones, the US Commerce Secretary 1940-1945 once said, "One of the greatest disservices you can do a man is to lend him money that he can't pay back." With this in mind, governments and investors should have a clear idea on where they want their money invested.
Nick Gartside is Head of Global Fixed Income at Schroder Investment Management. Opinions expressed in this article are entirely those of the contributing author.
(HK Edition 02/10/2010 page2)